FORMS OF BUSINESS ORGANIZATIONS
Accountants frequently refer to a business organization as an accounting entity or a business entity. A business entity is any business organization, such as a hardware store or grocery store, that exists as an economic unit. For accounting purposes, each business organization or entity has an existence separate from its owner(s), creditors, employees, customers, and other businesses. This separate existence of the business organization is known as the business entity concept. Thus, in the accounting records of the business entity, the activities of each business should be kept separate from the activities of other businesses and from the personal financial activities of the owner(s).
As you will see shortly, the business entity concept applies to the four main forms of businesses—single proprietorships, partnerships, and corporations. Thus, for accounting purposes, all four business forms are separate from other business entities and from their owner(s).
A single proprietorship is an unincorporated business owned by an individual and often managed by that same person. Single proprietors include physicians, lawyers, electricians, and other people in business for themselves. Many small service businesses and retail establishments are also single proprietorships. No legal formalities are necessary to organize such businesses, and usually business operations can begin with only a limited investment. The most attractive feature of a proprietorship is that there is no “double taxation”. Both proprietorships and partnerships do not pay taxes on profits at the business level. The only taxes paid are at the personal level—this occurs when proprietors and partners pay taxes on their share of their company’s income. On the other hand, a business owner is personally liable for all debts of his or her company. This is called unlimited liability. If you’re a sole proprietorship and the debts of your business exceed its assets, creditors can seize your personal assets to cover the proprietorship’s outstanding business debt.
A partnership is an unincorporated business owned by two or more persons associated as partners. Often the same persons who own the business also manage the business. Many small retail establishments and professional practices, such as dentists, physicians, attorneys, and many CPA firms, are partnerships. Unlimited liability is even riskier in the case of a partnership. Each partner is personally liable not only for his or her own actions but also for the actions of all the partners. If, through mismanagement by one of your partners, the partnership is forced into bankruptcy, the creditors can go after you for all outstanding debts of the partnership.
A corporation is a business incorporated under the laws of a state and owned by a few stockholders or thousands of stockholders. Almost all large businesses and many small businesses are incorporated. The corporation is unique in that it is a separate legal business entity. The owners of the corporation are stockholders, or shareholders. Stockholders do not directly manage the corporation. They elect a board of directors to represent their interests.
Accounting is necessary for all forms of business organizations, and each company must follow generally accepted accounting principles (GAAP).
TYPES OF ACTIVITIES PERFORMED BY BUSINESS ORGANIZATIONS
The forms of business entities discussed in the previous section are classified according to the type of ownership of the business entity. Business entities can also be grouped by the type of business activities they perform—service companies, merchandising companies, and manufacturing companies. Any of these activities can be performed by companies using any of the three forms of business organizations.
•Service companies perform services for a fee. This group includes accounting firms, law firms, and dry cleaning establishments.
•Merchandising companies purchase goods that are ready for sale and then sell them to customers. Merchandising companies include auto dealerships, clothing stores, and supermarkets.
•Manufacturing companies buy materials, convert them into products, and then sell the products to other companies or to the final consumers. Manufacturing companies include steel mills, auto manufacturers, and clothing manufacturers.
All of these companies produce financial statements as the final end product of their accounting process. These financial statements provide relevant financial information both to those inside the company—management—and to those outside the company—creditors, stockholders, and other interested parties. The next section introduces four common financial statements—the income statement, the statement of retained earnings, the balance sheet, and the statement of cash flows.
Test your understanding of the four types of businesses with this quiz. Remember to rate your confidence to check your answer: Maybe, Probably Definitely!
Important Points to Remember
- Business entity is any business organization, such as super market, or accounting firm, that exists as an economic unit.
- Business entity principle states that a business must be keep accounting records separate from its owners or other businesses.
- Ownership in business entities can be a sole proprietorship, partnership, or corporation. From the accounting perspective and its purpose these types of business are considered separate entities from their owners. The corporation is only one considered as a separate legal entity.
- A business can be a service company, merchandising company, or a manufacturing company.
NEW TERMS
Asset Things of value owned by the business. Examples include cash, machines, and buildings. To their owners, assets possess service potential or utility that can be measured and expressed in money terms.
Business Entity is any business organization that exists as an economic unit.
Liabilities Debts owed by a business—or creditors’ equity. Examples: notes payable, accounts payable.
Stockholders’ equity The owners’ interest in a corporation.
Sole Proprietorships are business entities owned by one single person.
Partnerships are business entities owned by at least two people.
Corporations are business entities owned by one person or many people called shareholders.
Service company is a business entity that provides services to the public and does not sell a product.
Merchandising companies are business entities selling a product and possibly a service to the public. A merchandising company purchases the products to be sold from outside vendors.
Manufacturing companies are business entities selling a product to the public that is made by the company using raw materials, direct labor and overhead.